SAN FRANCISCO – Bonds are the traditional way investors produce income from their portfolios. But you can generate additional money by tweaking your stock investments too.
Real estate and utility funds have been good sources of cash, but the big run-ups in the price of those funds have pushed yields lower.
"If you can get the same yield elsewhere with less risk and a more diversified portfolio, you're better off," said investment adviser Scott Kays of Kays Financial Advisory Corp. (search) in Atlanta.
Two good alternatives: balanced and equity-income funds, which blend stocks and bonds, boast competitive and even produce higher yields than many real-estate and utility funds — with less volatility.
A third strong option is convertible-bond funds, which combine some of the capital-gains potential of equities with the risk control of bonds.
Balanced funds lean toward a 50-50 mix of stocks and bonds, while equity-income funds generally have between 60% and 75% of their assets in stocks.
"Instead of going with growth stocks, you're primarily going to own stocks that have a dividend," said Kevin Ellman, a financial planner with Wealth Preservation Solutions (search) in Ridgewood, N.J. "Currently, dividends have favorable tax treatment. That makes your stock dividends even more attractive than a taxable bond dividend, and in some cases better than municipal bonds."
As September began, the 30-day average yield for balanced funds was 1.91% — about two-thirds of a real-estate fund's 2.81%, but with half the volatility, according to investment-research firm Morningstar Inc.
In addition, both balanced funds and equity-income funds — with a 1.76% average yield — beat utility funds' 1.54% yield.
Cast a wide net
"Utilities and real estate are pretty narrow sectors," said Russel Kinnel, Morningstar's director of fund research. "And real estate has had such a run, I would be hesitant to add more at this point. So I generally recommend diversified dividend plays."
Among Kinnel's favorites are T. Rowe Price Equity Income Fund (PRFDX) , which yields 2.3%, and Vanguard Wellesley Income Fund (VWINX) , a balanced offering with a 3.91% yield.
"These are funds you can buy and not worry much about," Kinnel said. "They're well run, and you can depend on that year in and year out."
Kinnel also suggests the Vanguard Wellington Fund (VWELX) , another balanced portfolio run by Wellington Management Co., which also oversees Wellesley Income.
"You have a very conservative strategy even though the bond stake isn't great," Kinnel said of Wellington, which yields 2.74%. "They're not going to stretch to produce yield."
The trade-off with equity-income and balanced funds is a lower total return than you could expect from real estate and utility investments — but still potentially more than you'd get from a traditional bond or money-market fund.
Real estate and utility funds each averaged 24% annualized gains for the three years through Sept. 22, according to Morningstar, versus 16% for large-cap value funds, which include many equity-income portfolios, 7.6% for Morningstar's "conservative allocation" category, which balanced funds dominate, and 14% for convertibles funds.
Know your fund basics
Always keep two caveats in mind when buying income funds.
First, pay strict attention to costs. Fund expenses come directly out of dividend income, so lower fees give you more cash.
Second, know how a fund gets its yield.
"What kind of bonds are they using?" asked Kays, the Atlanta financial adviser. "These are not designed to be high-growth, high-risk funds, but sometimes mangers will stretch for the extremes. You've got to be aware of that."
Quality is even more crucial with convertible-bond funds. Look at the top 10 holdings, Kays said: "Are they good quality converts? Do they have converts of companies whose rating is junk? The instrument itself tends to be fairly low risk, but if you're using it with high-risk companies, then it becomes a high-risk instrument."
Convertibles are bonds that can be swapped for common stock at a preset rate. They don't rise as much in bull markets as stocks, but the yield cushions downturns. Convertible funds yield 2.3% on average, with a risk level on par with their balanced-fund rivals, according to Morningstar. Convertible funds, with their stock-like characteristics, can also produce better total returns than other income-oriented funds.
Kays recommends the Calamos Growth & Income Fund (CVTRX) , which has more than 60% of its $5.2 billion portfolio in convertibles. Morningstar shows a 12-month trailing yield of 1.57% for the fund, which declines to provide current data.
Jim Peterson, a vice president at the Schwab Center for Investment Research (search), recommends Northern Income Equity Fund (NOIEX) , which has about 50% of assets in convertibles and yields 2.62%.
Said Peterson: "Income can come from a variety of sources - not strictly fixed income."
* Trailing 12-month yield
Source: Morningstar Inc. and fund companies (Data through 9/22/05)